Sticky Inflation

The monthly numbers are out, and while the rate of inflation is well off the 2022 peak, price hikes remain uncomfortably high.

The U.S. Bureau of Labor Statistics reported that the Consumer Price Index (CPI) and the core CPI, which excludes food and energy, both rose 0.3% in November. The CPI is up 2.7% versus a year ago.

The core CPI held at 3.3% in November. And that illustrates a problem. Inflation has gotten stuck at a still-elevated level. The annual core CPI has been running at 3.3% for 4 of the last 6 months (Fig 1).

A more detailed review highlights what’s driving inflation (Fig 2). Supply chains have righted themselves, and the sharp rise in inflation for consumer goods has been replaced by deflation (falling prices).

It’s a different story for services. Historically, services such as rent, health insurance, and auto repair have risen at a faster rate than consumer goods.

At 4.5% annually last month, services remain high but are in a gradual downward trend.

Why do investors care? The slowdown in inflation has encouraged the Federal Reserve to reduce interest rates. This week, the Fed is widely expected to cut the fed funds rate by another 25 basis points (bp, 1bp = 0.01%). If so, it will mark a total of 100 bp since September.

Given mostly upbeat economic data and still elevated inflation, it’s generally expected that the Fed will briefly pause its rate-cut campaign in January. Few, however, believe the Fed will signal rate hikes, but it may take a more cautious approach to lowering rates in the new year.

If the Fed adopts a more thoughtful approach at Wednesday’s meeting, we may experience some short-term volatility.

Investors, however, are not entirely reliant on Federal Reserve rate cuts to drive stock prices higher.

While stocks are seemingly priced for perfection and any disappointments can create conditions for a pullback, economic growth and rising corporate profits remain supportive of stocks. Further, enthusiasm in artificial intelligence has yet to abate.

Job Growth and Economic Growth

On Friday, the U.S. Bureau of Labor Statistics (BLS) reported that nonfarm payrolls rose by 227,000 in November, which came in just above the consensus forecast of 214,000 (CNBC). The unemployment rate, measured by a different BLS survey, ticked up to 4.2% from 4.1%.

November’s increase was a recovery from just 36,000 in October, when hurricanes and Boeing’s (BA $154) strike negatively affected the data. In part, November represented a catch-up.

Job growth last month was concentrated in health care, which rose by 72,000, and the leisure and hospitality sector, which grew by 53,000. All levels of government increased by 33,000.

Strictly speaking, gains were narrowly concentrated in November, which is something we’ve seen recently.

However, there appears to be a disconnect between solid economic growth and a slowdown in job creation.

Over the medium and longer term, economic growth supports job growth. If sales are expanding at most companies, these same firms would be expected, on average, to add workers to support their growing businesses. In addition, new businesses would be expected to hire.

The graphic below highlights the average change in nonfarm payrolls per quarter (left side) and compares the change with quarterly Gross Domestic Product ((GDP), right side).

Robust GDP in 2021 coincided with robust employment growth, as the re-opening of the economy boosted both economic output and rehiring.

But look what’s happened since the 3^rd quarter of 2022. GDP has been steady and solid, averaging an increase of 2.9% per quarter. Soft economic landing? Hardly. But job growth has slowed.

Perhaps it can be explained by quirks in one or both surveys. But it’s a conundrum.

With inflation above the Fed’s target of 2% per year, GDP argues against rate cuts. However, the moderation in job growth has encouraged the Federal Reserve to reduce interest rates, even as GDP expands.

Another Strong Earnings Season

Our discussions have included Fed policy, the economy, and the surge in inflation since the pandemic. Why? In large part, they are all a part of the stock market pricing equation.

Yet, so are corporate profits, and profits for the largest U.S.-based companies are heavily influenced by economic activity.

Undoubtedly, there are a few companies that execute well in most environments, while others reside in industries that are more resilient to economic downturns.

However, most companies in the S&P 500 rely on a stiff tailwind from economic growth. And when an economic downturn eventually occurs, profits in the S&P 500 turn south.

A recession has yet to happen, but when it occurs, profits fall, as we experienced in the 2008-09 and 2020 recessions.

A numerical review

With 95% of S&P 500 companies having reported in Q3, S&P 500 profits are projected to rise a solid 8.9% compared to one year ago, according to LSEG. That is up from a 5.3% forecast as of October 1.

Typically, projections rise through the quarter as firms, on average, typically top conservative forecasts.

More impressively, 76% of S&P 500 firms that have reported have beaten the consensus profit forecast, which compares favorably to the long-term average of 67%.

And there’s more. Companies that top profit estimates are beating by a wider-than-average margin in Q3: 7.6% versus the historical average of 4.2%.

A strong reason for Q3’s upbeat performance is technology, which is projected to rise by 19% in Q3.

Bottom line

Over the medium and longer term, the economy is a significant underlying support for corporate profits. Put another way, rising corporate profits have historically been a magnet for investor cash over the longer term.

When the economy is expanding, companies, individuals, and families buy more ‘stuff.’ And it is that stuff (goods and services) that drives profits. It’s not a one-to-one relationship, but it is a significant driver of earnings.